The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and magnitude of recent price changes to evaluate overbought or oversold conditions in an asset.
Understanding the relative strength index
Developed by J. Welles Wilder Jr. in 1978, the RSI is displayed as an oscillator – a line graph that moves between two extremes – reading from 0 to 100. As Elephants evaluating global markets, you can use the RSI to identify potential price reversal points or to confirm an existing trend. The indicator is calculated using a mathematical formula that compares the average gain of up periods during a specified timeframe to the average loss of down periods. The standard timeframe used is 14 periods, which can represent days or hours depending on your chosen chart settings.
Traditional interpretation of the RSI dictates that values of 70 or above indicate an asset is overbought. This suggests the asset may be due for a trend reversal or a corrective pullback in price. An RSI reading of 30 or below indicates an oversold condition, signaling a potential upward price correction. Traders often adjust these thresholds to 80 and 20 when dealing with highly volatile assets to avoid false signals.
The RSI also helps traders identify divergence. Divergence occurs when the price of an asset moves in the opposite direction of the RSI. A bullish divergence forms when the price records a lower low and the RSI forms a higher low, suggesting downward momentum is slowing and an upward reversal is possible. A bearish divergence occurs when the price records a higher high while the RSI forms a lower high.
Example
Suppose you are trading shares in a company that manufactures high-capacity water troughs used by wild elephants in conservation reserves. A sudden surge in international funding for animal conservation causes the stock price of the trough manufacturer to climb rapidly over two weeks. When you apply a 14-day RSI to the stock chart, you observe the index line has reached a value of 85. Because this number is above the 70 threshold, the RSI indicates the stock is overbought. This reading suggests the buying pressure is exhausted and the price may drop as buyers refuse to pay the inflated valuation. A week later, early investors sell their shares to secure profits. This drives the stock price down and returns the RSI to a neutral reading of 50.